Is the world falling apart?

With the exception of wartime, "the public finances in the majority of advanced industrial countries are in a worse state today than at any time since the industrial revolution. Restoring fiscal balance will be a drag on growth for years to come." —Willem Buiter, Citigroup's top economist

If you have to pose the question in today's title, then you have also gone a long way toward answering it. When I say "the world" I am referring to the global economy in the short-term (within 1 year). I don't doubt "the world" is falling apart in the long-term, but that will takes years (oil price shocks) or decades (dead oceans) to unfold. Obviously, shorter-term outcomes influence the timing of (still inevitable) longer-term outcomes.

In 2010 the situation feels a lot like 2008, only worse. Emotions are running high. We are looking at the possibility of a very large deflationary dip in global demand for goods & services, which is why everybody is so freaked out—a Global Depression. We live in times prone to hysteria, but never in my lifetime has there been so much fear about market & sovereign outcomes. (These are increasingly the same thing.)

The reasons for our fears & worries are in plain sight.

Within a year's time, will the Euro (and thus the Eurozone) still exist? Will various European nations accept the new austerity?

When will China's over-stimulated, overheated economy cool down? When will their asset bubbles collapse?

Will the United States fall back into recession because of high, sustained unemployment and a housing market on life-support?

These are not separate questions, for in a globalized economy every nation's economic health depends more and more on that of all the others. Contagion is the rule, not the exception. The various regions making up the world economy are connected by trade, finance (investments, inter-bank dependencies), swap lines between central banks and currency exchange rates, and these connections are not simple.

For example, stronger currencies (relative to others) hinder exports and promote imports. Financial investments and trade arrangements are usually denominated in foreign (local) currencies and hedged through foreign exchange (FX) derivatives contracts (currency & forex swaps or options) currently worth tens of trillions of dollars on the world market. These contracts are supposed protect investors against currency exchange rate volatility. This many-tentacled financial octopus may not be stable when tested under these new economic circumstances.

Exchange rates may be volatile for months (or years) to come. It's not clear how this is going work out. Right now the Euro is falling like a brick against the dollar. The Chinese peg their dollar (the Yuan) to the American dollar, but no doubt did not anticipate this large strengthening of our dollar against the Euro. Traditional trade relationships are being altered significantly. These previous arrangements will be replaced by—what?

Doubtless there will be a considerable slowdown of economic activity in the Eurozone. It doesn't appear that subsidized workers in Europe will easily accept the new austerity terms. Social unrest is spreading. And with all the turmoil in Europe, only a few observers are paying attention to China. I find it alarming that the Chinese have been a net importer recently. This new development is purely a function of China's overheated economy. But now China's imports are headed south again, and their exports can't be far behind.

The government in Beijing has been aggressive in using money policy to damp down property speculation as a way to steer China’s hot economy away from a meltdown. Avoiding dangerous bubbles makes long-term sense, but there have been short-term costs: the benchmark Shanghai Composite Index is down more than 20 percent year-to-date. It fell 5 percent on Monday alone...

Four straight months of strong year-over-year recovery in China’s exports was likely a key factor considered by the government when it imposed anti-property speculation policies last month. But the sovereign debt crisis in the Eurozone is another key factor. Europe is China’s largest trading partner, and the debt crisis has led to a significant devaluation of the euro against the Chinese yuan.

The yuan, which is pegged to the U.S. dollar, is up 14 percent against the euro in just the past four months. The stronger yuan makes Chinese-made products more expensive in the eurozone, and this hurts exporters.

The three-month trend of China’s imports, a leading indicator of future exports, has already headed down. Should a meaningful export deceleration occur in the intermediate term, Chinese authorities may reverse policies to protect economic growth.

China and some lesser emerging economies are carrying the world economy on their collective backs at this point, but that situation could change quickly. These developing economies taken altogether only amount to about 8-9% of global GDP, with China accounting for the lion's share.

There's a damn good chance that the Chinese will not be able to control the rampant speculation created by their massive stimulus. My view is that we should not be calculating whether their various bubbles will collapse. Instead, we should be trying to figure out when they will collapse, and then trying to figure out what the effects on the global economy will be. Economic bubbles always end in tears sooner or later—there are no exceptions.

And what about here in the Good 'Ole U.S. of A? That's not my subject today, but suffice it to say that we are The Smartest Kid In the Stupid Class—we only look good by comparison with all the other blockheads. The danger is that our newly discovered fiscal "virtue" will only intensify our already dangerous complacency. Let's face it: America has gotten away with many, many irresponsible things (at least for the time being) only because our dollar is the world's reserve currency and we own the money printer. Without our privileged status, these clowns running Congress, the Treasury and the Central Bank would have been tossed out on their ear a long time ago would have been exposed long ago as the unaccountable, spendthrift, corrupt fools that they are.

Is the world falling apart? My best guess is that there's at least a 50% chance of a Global Depression starting this year or early next year. The oil price is already crashing as the dollar strengthens in anticipation of a sharp downturn in global economic activity. A lot of things have to go right in Europe, in China and in the United States to avoid this outcome. There are good reasons why everybody is running scared. Here's a video to watch as you contemplate all this.

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